An Update on the Securitization of Small Business Loans
Published September 1, 1997 | September 1997 issue
There have been at least three developments in small business securitization, in addition to the rise of credit scoring, since The Region last looked at the issue (see "Will the Securitization Revolution Spread?" September 1995).
First, the amount of small business loans that have been securitized has nearly doubled since fall 1995. While no exact numbers were available, it appeared that less than $900 million in small business loans had ever been securitized at that time. An equally rough update suggests that about $2 billion in small business loans have now been securitized. This figure remains small when compared with the roughly $175 billion in commercial and industrial loans under $1 million outstanding as of June 1996. SierraWest Bancorp of Truckee, Calif., carried out a particularly noteworthy transaction being the first bank to securitize the unguaranteed portion of so-called 7(a) loans, which receive a partial guarantee from the U.S. Small Business Administration (SBA).
Second, Congress made the SierraWest transaction possible by passing legislation in 1996 that forbid the securitization of the unguaranteed parts of SBA loans after March 31, 1997, unless the SBA issued rules that treated all lenders equally. Previously, the SBA did not allow banks and other depositories to engage in such securitizations, while it did allow securitization by nondepository lenders, such as a subsidiary of the Money Store. The SBA issued a proposed rule in February 1997 that allowed securitization for all, while requiring securitizers to effectively own a 5 percent interest in each securitized loan. The SBA also specified three methods to structure lenders' interest in the loans.
The SBA provides an average guarantee of repayment on 75 percent of the 7(a) loan (down from 90 percent several years ago). The SBA does not want lenders making loans on which only the SBA and investors could lose funds when defaults occur. Therefore, the SBA wants lenders to retain an ownership stake so that they will lose some money upon defaults even if they sell the loan.
Nondepositories that would become subject to these loan ownership restrictions for the first time have lodged numerous complaints. They argue that the 5 percent rule is arbitrary and inefficiently requires the same credit protection and structure for all lenders. Moreover, they believe that investors already act to ensure that lenders bear risk in securitization. Securitizers, for example, already bear the risk of loss from certain delinquent loans. Current structures also ensure that originators earn higher returns when losses are low. In response to the controversy, the SBA issued an interim rule in April 1997 allowing depository and nondepository institutions to securitize unguaranteed 7(a) loans subject to a case-by-case review. Finally, several firms have proposed ventures that should make the securitization of small business loans originated by small lenders more likely. A small lender may not make enough small business loans to justify the expense of securitization. A larger firm that buys loans from smaller lenders and securitizes a large volume on a regular basis could better take advantage of cost efficiencies.
However, the heterogeneity of small business loans has made it difficult for a firm to act as a conduit to the securitization market for small business lenders. In one of the new ventures, a firm that sells software to banks has teamed with a securitization specialist to create the "Loan Origination Management and Exchange" (Lori Mae for short). Lori Mae hopes to facilitate homogenous loan pools by securitizing only loans originated with the co-owner's software. A second venture called the Small Business Funding Corp. plans on purchasing the unguaranteed portion of SBA 7(a) loans from smaller lenders. This firm counts on the rise of credit scoring to help standardize small business loans and make estimates of expected cash flows reliable. Finally, California Imperial Bancorp announced that it would start purchasing and securitizing small business loans in 1998.